Global Economics

As Taxes Rise in Japan, Will Abenomics Turn Into Abegeddon?

Since coming into office in December 2012, Japanese Prime Minister Shinzo Abe has taken many controversial steps to revive Japan’s moribund economy. Tomorrow comes the riskiest move yet. For the first time in 17 years, Japan is raising the consumption tax. With the start of the new fiscal year on April 1, Japanese consumers will suddenly have to pay an 8 percent tax instead of 5 percent. That hike could endanger Japan’s fragile recovery.

On the plus side, the increase should help Japan make a dent in its staggering public debt, which is 240 percent of gross domestic product. By raising the consumption tax to 8 percent, the government should take in an additional 4.5 trillion yen ($43.6 billion) in the new fiscal year. That’s close to 1 percent of Japanese GDP.

Still, history is not on Abe’s side. Japanese leaders who have raised the consumption tax have not lasted long. Prime Minister Noboru Takeshita introduced the tax in April 1989, a move that didn’t help win supporters a few months later when his government was caught up in a stock-for-favors scandal. By June, he was gone. The government of Tomiichi Murayama, the first Socialist prime minister in decades, raised the tax in 1994—and by the next lower-house election, he was gone, too. The man who followed him, conservative Ryutaro Hashimoto, raised the tax to 5 percent in 1997 and was out of office the following year.

The 1997 tax increase, the same year the Asian financial crisis hit many of Japan’s major trading partners, weakened the Japanese economy, which averaged subzero growth for five years. As Bloomberg View columnist William Pesek wrote last October, that experience has led Alexander Friedman, chief investment officer at UBS (UBS), to warn of stagflation this time around. Instead of Abenomics, Japan could face “Abegeddon.”

Are there signs of decline already? One ominous clue: Industrial production last month fell 2.3 percent compared with January. Economists surveyed by Bloomberg had been expecting a 0.3 percent gain. Still, the bad news now may turn out to be good news later, since the drop in manufacturing shows that companies are already adjusting for a drop in demand and so won’t have to make major cutbacks in the months ahead. “The fall off in the second quarter should be modest,” Kiichi Murashima, Citigroup’s (C) chief economist in Tokyo, told Bloomberg News.

For now, economists are hopeful that Japan can manage the shock from the tax increase without falling into a recession. Japanese GDP will expand at an annual rate of 4.4 percent in the first quarter of 2014, according to a monthly survey of 45 economists by Bloomberg, and then contract 3.5 percent in the second quarter. By the third quarter, the economy should be growing again, with GDP growth expected to come in at 2 percent. “Fears of a meltdown are likely overdone,” according to Tom Orlik, Bloomberg economist in Beijing. In a note published today, Orlik argues that Japanese companies are much healthier than they were in 1997. Moreover, unemployment is not on the rise, as it was then. And unlike then, Asia isn’t in the beginning of a major crisis.

So no Abegeddon means no problem, right? Not quite. Abe has been lobbying for months to persuade Japanese companies to raise wages. Japanese salaries have dropped 15 percent over the past 15 years, and even with companies now enjoying strong profits thanks to the weaker yen, many lack the confidence to offer significant raises to their workers. Toyota Motor (TM), for instance, is on a roll, scoring record profit, but the automaker on March 12 said it would give its workers a measly 0.8 percent raise in base pay.

“The real risk it that the consumption tax will exacerbate the central problem with Abenomics—a blow to household wealth and spending power as price rises accelerate ahead of income,” writes Orlik. Abe has succeeded in conquering deflation: Consumer prices jumped at an annual 1.5 percent rate last month. But with the tax increase making prices even more expensive, Japanese consumers can’t keep up. “The problem is that tepid increases in wages have left households with falling real income.”

With inflation returning to Japan but companies not offering workers much in the way of salary increases, Japanese consumers are already cutting back on their spending. On Friday, the government announced household spending in February fell 2.5 percent. That drop was the first in six months and came as a surprise: With the consumption tax going up in April, Japanese consumers were supposed to do their spending now, while the tax rate was still at 5 percent. Instead, consumer spending went in reverse, a lot earlier than expected.